SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarter ended March 31, 2005

Commission file number 1- 4373
____________________

THREE-FIVE SYSTEMS, INC.

(602) 389-8600

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

     Securities registered pursuant to Section 12(b) of the Exchange Act:

THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2005

TABLE OF CONTENTS

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ITEM 1. FINANCIAL STATEMENTS

THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(Dollars in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements

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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(Dollars in thousands, except per share data)

The accompanying notes are an integral part of these condensed consolidated financial statements

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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(Dollars in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements

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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note A Organization and Operations:

Three-Five Systems, Inc. (together with its subsidiaries, herein referred to as “we,” “us,” or “the Company”) is a global provider of electronics manufacturing services, or EMS. We design and manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, and complete systems for customers in the computing, consumer, industrial, medical, military, and telecommunications industries. Until recently, our design and manufacturing services included a distinctive competence in display modules and systems and the integration of display modules and systems into other products. We refer to the business involving displays as the Display business. All business other than the Display business is referred to herein as the EMS business.

We sustained substantial losses in the past several years. Those losses and certain acquisitions we completed had the effect of reducing our cash balances. As a result, we retained SG Cowen & Company to review strategic alternatives aimed at maximizing stockholder value. Based on that review, we sold or closed down two portions of our Display business in the first quarter of 2005. As a result, at the end of the first quarter we were no longer in the Display business except for the large display panel operations in Marlborough, Massachusetts. In May 2005, we sold those large display panel operations.

We have also signed a letter of intent to sell our business in Manila, which is the radio frequency, or RF, portion of our EMS business, in exchange for cash. This letter of intent is nonbinding; therefore, there is no assurance that any business transaction will be effected or what the timing and terms of any such business transaction could be. If the sale of Manila is completed, our only remaining business will be the Redmond and Penang portions of our EMS business. We continue to use SG Cowen to review strategic alternatives with our remaining business. In the meantime, we continue to focus on cost reductions in that business, including moving our corporate headquarters to Redmond.

As a result of the foregoing, all of our Display business other than the large display panel operation business in Marlborough, Massachusetts is reported in our financial statements this quarter as discontinued operations, as further described below. In addition, since the RF portion of our business was held for sale in the first quarter of 2005, that business is also included in discontinued operations.

The accompanying condensed unaudited financial statements have been prepared by management. They should be read in conjunction with our December 31, 2004 financial statements, which were included in our Form 10-K Report filed on April 1, 2005 with the Securities Exchange Commission (SEC) and our Form 10-K/A Amendment No. 1 filed on April 22, 2005 with the SEC. Our financial statements for the year ended December 31, 2004 received an unqualified opinion and included an explanatory paragraph regarding our ability to continue as a going concern at December 31, 2004. Our recurring operating losses and use of cash in our operating activities during 2004 and the first quarter of 2005 are indicators that led our auditors to believe that we may be unable to continue as a going concern for a reasonable period of time. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classifications of liabilities that might be necessary should we be unable to continue as a going concern. Our continuation as a going concern is dependent upon a combination of our ability to generate sufficient cash flows from operations, to obtain additional debt or equity financing, or to sell additional assets to meet our obligations on a timely basis, and ultimately to attain successful operations.

Notwithstanding the foregoing, and based upon our cash balances at the end of the first quarter, our expected use of cash in 2005, and the $9.4 million that we recently received upon the sales of operations to International DisplayWorks, Inc. and Video Display Corp., we believe that we have adequate sources to fund our remaining operations and planned expenditures through 2005, as well as to meet our contractual obligations. We also expect to obtain a line of credit in Penang for $4 million. The expected use of funds through the rest of 2005, however, is based on our current judgments and forecasts. Actual results could prove materially different and, in such instances, may require additional funds. We cannot provide assurance that additional asset sales, such

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as the sale of the Manila operations, loan commitments, or other methods of financing will be available for any such unexpected additional requirements or, if available, that they will be on terms acceptable to us.

Note B Discontinued Operations:

In March 2005, we determined to discontinue our distribution of certain display products that we licensed from Data International. The decision follows the exercise by us of our right to rescind a technology licensing agreement, or TLA, that was entered into during January 2003 with Data International Co, Ltd. Revenue from those Data International products in 2004 equaled approximately $17 million. The TLA designated us as the exclusive distributor of certain Data International display products in the Americas in return for deferred payments to Data International of $3.9 million. Through the end of 2004, we had paid approximately $2.4 million to Data International, and a final payment of approximately $1.5 million was due in January 2005.

We determined in the first quarter of 2005 that certain of the specified Data International display products have been simultaneously available in the United States through a third party and that we had not been provided exclusive distribution rights to the United States market as required by the TLA. Based on that determination, we believe that the TLA was breached, and we exercised our rights of rescission. We notified Data International in February 2005 that we would not make the final $1.5 million payment to Data International that was due in January 2005. We also asserted damages of at least $2.5 million, plus interest and other expenses, against Data International. We notified Data International that we offset our claimed damages against money owed by us to Data International for product purchases. We recently filed a complaint against Data International in Arizona requesting a declaratory judgment for breach of contract. Data International also filed a lawsuit against us in federal district court in Arizona asserting breach of contract.

On March 30, 2005, we signed a definitive agreement to sell the assets of our small form factor display business to International DisplayWorks, Inc. That transaction closed in April. The small form factor display assets sold included 100% of the outstanding shares of Three-Five Systems, Beijing, Inc., our former China-based display subsidiary, and display-related equipment housed at our Manila, Philippines factory. The sale did not include the large panel display business operated out of our Marlborough, Massachusetts facility and our electronic manufacturing services (EMS) business located in Redmond, Washington, Penang, Malaysia, and Manila, Philippines.

We estimate the total value of the transaction to be in the range of between $8 and $20 million, which will come from a variety of components. These components include the following:

	•	$8 million in cash recently paid to us upon closing and government approval in China;
	•	Up to an estimated $3 million in additional cash to be paid to us over time based upon working capital adjustments; and
	•	An estimated zero to $9 million in the common stock of International DisplayWorks, Inc. to be paid to us in May 2006, based on a percentage of the transferred display business revenue for the preceding 12-month period, if certain minimum revenue targets are met.

At closing, International DisplayWorks, Inc. assumed the obligations of TFS Beijing, including a $2.4 million line of credit we had previously established with a bank located in China.

Our display business of products from Data International and our small form factor business were previously part of our Display segment. Sales from these two businesses were $5.8 million and $12.9 million for the first quarters of 2005 and 2004, respectively. These two businesses generated $9.5 million and $2.4 million of the loss included in discontinued operations for the first quarter of 2005 and 2004, respectively.

As it relates to our discontinuation of our business related to products supplied by Data International, we recorded a charge of $2.1 million for the write-off of the distribution right purchased from Data International. Since the litigation has not been concluded, however, we have not adjusted the note payable and outstanding accounts payable.

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In connection with the sale of assets to International DisplayWorks, Inc., we recorded a loss of $5.0 million from the write down of assets, which considered only the initial $8 million received when calculating the write down on these assets. The various earn-outs were classified as contingent gains and will be recorded by us, if and when received. As a result, we wrote off $2.5 million of inventory, $0.7 million of mask sets and $1.8 million of property, plant, and equipment.

We have also included our RF business under discontinued operations because during the first quarter we had established a plan to sell this business in the next 12 months. This business was previously part of our EMS segment. We have signed a non-binding letter of intent to sell this business and expect to close by the end of the second quarter. Although the sale cannot be assured, we have used the current estimated sales price of approximately $3.0 million to determine the impairment of assets currently in this business. Sales from this business were $2.1 million and $2.6 million in the first quarter of 2005 and 2004, respectively. The total loss from discontinued operations for the RF business was $5.8 million and $0.4 million in the first quarter of 2005 and 2004, respectively. The impairment of assets totaled $5.2 million in the first quarter of 2005.

In May 2005, we sold the large panel display business operated out of our Marlborough, Massachusetts facility for $1.4 million to Video Display Corp. At March 31, 2005, we had not finalized our plans for this business and not yet committed to a plan to sell the business. As a result, that business will be reported as discontinued operations commencing in the second quarter of 2005. In part based on the lower than expected operating results of this business in the first quarter of 2005, forecasted revenue revisions, and the sale price realized in May 2005, we determined that $7.2 million of goodwill associated with the display monitor business was impaired. This charge appears under Impairment of Goodwill.

Net loss from all discontinued operations was $15.2 million and $2.8 million in the first quarter of 2005 and 2004, respectively. There was no tax benefit in 2004 or 2005 for the discontinued operations. Sales from all discontinued operations were $7.9 million and $15.5 million in the first quarter of 2005 and 2004, respectively.

During 2004, we entered into a series of agreements with Vitelcom, a former European customer, with regard to its payment of an outstanding balance due us. As of March 31, 2005 and December 31, 2004, $1.4 million remained unpaid under that revised payment schedule. During the first quarter of 2005, we reserved $0.4 million against this unpaid amount. In addition, we filed a lawsuit against Vitelcom in Spain for the outstanding balance due us.

In February 2005, we vacated our office space in Swindon, England. A charge of approximately $15,400 was recorded in February 2005 to recognize future costs associated with the continuing lease obligation for this vacated facility. We have undertaken efforts to sublease this facility, and the charge is net of estimated future rental income we expect to receive. At March 31, 2005, the amount to be amortized was all considered to be current.

In March 2005, we vacated our office space in Orlando, Florida. A charge of approximately $26,000 was recorded in March 2005 to recognize future costs associated with the continuing lease obligation for this vacated facility. We have undertaken efforts to sublease this facility, and the charge is net of estimated future rental income we expect to receive. At March 31, 2005, the amount to be amortized was all considered to be current.

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The major classes of discontinued assets and liabilities included in the Condensed Consolidated Balance Sheet as of March 31, 2005 were as follows:

Note C Cash and Cash Equivalents:

For purposes of the statements of cash flows, all highly liquid investments with an original maturity of three months or less are considered to be cash equivalents. Cash equivalents consist of investments in money market mutual funds. A portion of our funds held in money market mutual funds are invested in repurchase agreements. These repurchase agreements are collateralized by U.S. Treasury and Government obligations. In the first quarter of 2005, Silicon Valley Bank (SVB) required us to make a cash deposit to secure a $600,000 letter of credit, which SVB had issued to the lessor of our building in Redmond. This cash deposit is shown on our Balance Sheet at March 31, 2005 as Cash on Deposit Maintained for Compensating Balances. Cash and cash equivalents at December 31, 2004 and March 31, 2005 consisted of the following:

Note D Accounts Receivable, net:

We estimate sales allowances based upon historical experience of sales returns. To establish our allowance for doubtful accounts, we perform credit evaluations of our customers’ financial condition, along with analyzing past experience, and make provisions for doubtful accounts based on the outcome of our credit valuations and analysis. Our allowance for doubtful accounts was $83,000 and $53,000 as of March 31, 2005 and December 31, 2004, respectively. Allowance for sales returns was $120,000 and $208,000 as of March 31, 2005 and December 31, 2004, respectively.

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Note E Inventories:

Inventories are stated at the lower of cost (first-in, first-out) or net realizable value and consisted of the following at:

Shipping terms with one of our major customers is FOB destination, and many of those products are shipped by sea, taking four to six weeks to reach their destinations. As a result, product in transit that was in our finished goods inventory was $2.5 million as of March 31, 2005 compared with $3.1 million as of December 31, 2004.

We scrap inventory when materials are determined to be defective, damaged, or no longer required. We also write down our inventory for estimated obsolescence or un-marketability based upon assumptions and estimates about future demand and market conditions. If actual market conditions are less favorable than those assumed by us, additional inventory write downs may be required. We have had a significant history of inventory charges and write-offs. In 2004, we wrote off $2.1 million as excess inventory. In the first quarter of 2005, we wrote off $0.7 million of excess inventory, primarily in our EMS segment, which related primarily to discontinued programs and excess inventories at our Redmond, Washington facility.

Note F Property, Plant, and Equipment:

Property, plant, and equipment is recorded at cost and is depreciated using the straight-line method over the estimated useful lives of the respective assets. Lives for the major asset categories are as follows:

Major additions and betterments are capitalized, while replacements, maintenance, and repairs that do not extend the useful lives of the assets are charged to expense as incurred. Property, plant, and equipment consisted of the following at the dates indicated:

As of December 31, 2004, we had invested $2.1 million in our ERP software and implementation. During the first quarter of 2005, we made additional investments of $0.4 million into the ERP project. In February, this project was put on hold as we evaluated our situation regarding the sale of our Manila facility, the move of our corporate headquarters to Redmond, Washington, and our other strategic alternatives to maximize stockholder value. During the second quarter of 2005, we determined that we would not proceed with the implementation. As a result of that decision, and as part of our ongoing review of assets, we wrote off the total investment of $2.5 million in the first quarter of 2005.

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Note G Intangibles:

Intangibles consist of customer lists of our EMS segment that were acquired during our acquisition of ETMA in December 2002. SFAS 142, Goodwill and Other Intangible Assets, requires purchased intangible assets with finite lives to be amortized over their useful lives. Purchased intangibles are recorded at cost and amortized using the straight-line method over the estimated useful lives of the respective assets, which is three years.

Intangible assets consisted of the following:

Intangible asset amortization expense for the three months ended March 31, 2005 and 2004 was $166,000 and $318,000, respectfully. Amortization expense in 2004 also included amortization of customer lists acquired in our acquisition of AVT in September 2002.

Estimated annual amortization expense through 2009 and thereafter related to intangible assets reported as of March 31, 2005 was as follows:

Note H Goodwill:

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill is analyzed for impairment, on at least an annual basis, or more frequently under certain circumstances, and written down when impaired rather than being amortized.

Changes in goodwill from December 31, 2004 to March 31, 2005 were as follows:

In the first quarter of 2005, we determined that $5.7 million of goodwill in our EMS reporting unit and $7.2 million of goodwill in our Display reporting unit had been impaired. The amount of the impairment was determined in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. The

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decision to impair the goodwill was the result of first quarter 2005 operating results, forecasted revenue revisions, the recent sale of the Marlborough business in May 2005, and valuations set forth in indications of interest we have recently received with respect to one or more of our businesses in our EMS segment. In May 2005, we completed the sale of our Marlborough business for $1.4 million, which indicated that $500,000 of goodwill should be recorded at March 31, 2005.

Note I Other Assets:

Other assets consist primarily of the $2.0 million note receivable that we received in connection with the sale and leaseback of the Tempe building.

Note J Other Accrued Liabilities:

Accrued liabilities include, among other things, accrued compensation, current portion of deferred building rent and current portion of lease abandonment costs. See Footnote O for additional details.

Note K Customer Deposits:

As of March 31, 2005 and December 31, 2004, customer deposits included approximately $3.3 million and $2.9 million, respectively, of invoices issued to a specific customer in accordance with the terms and conditions of that customer’s purchase order. The invoices are to cover costs associated with the establishment of the supply chain and the long lead times required for materials used in the manufacturing process.

Note L Deferred Sale Leaseback Gain:

In December 2004, we sold our Tempe building for approximately $11.3 million less selling costs of approximately $500,000. Under the terms of the sale, we received net cash (after expenses) of $8.8 million and a promissory note of $2.0 million payable in five years, resulting in a $2.7 million gain on the sale of that building. The $2.7 million deferred gain on the sale and leaseback of our Tempe, Arizona corporate facility will be amortized over the five-year term of the lease. During the first quarter of 2005, we recognized $0.1 million of the gain.

Note M Stock Compensation:

Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, we account for options granted to our employees pursuant to Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, under which no compensation cost has been recognized. However, we have computed compensation cost, for pro forma disclosure purposes, based on the fair value of all options awarded on the date of grant, utilizing the Black-Scholes option pricing method with the following weighted assumptions: risk-free interest rates of 2.80%, and 4.18% for the three months ended March 31, 2004, and 2005; expected dividend yields of zero for all scenarios; expected lives of 5.7 years for 2004, and 3.9 years for 2005; and expected volatility (a measure of the amount by which a price has fluctuated or is expected to fluctuate during a period) of 79.6%, and 77.8% for the three months ended March 31, 2004, and 2005, respectively. The compensation costs for the three months ended March 31, 2004 and 2005 are not tax-effected. Had compensation cost for these plans been determined consistent with SFAS No. 123, our net loss and loss per share would have been as follows:

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Note N Earnings Per Share:

Basic net (loss) per common share is computed by dividing net (loss) by the weighted average number of common shares outstanding during the year before giving effect to stock options considered to be dilutive common stock equivalents. Diluted net (loss) per common share is computed by dividing net (loss) by the weighted average number of common shares outstanding during the year after giving effect to stock options considered to be dilutive common stock equivalents. Set forth below are the disclosures required pursuant to SFAS No. 128 – Earnings per Share:

For the three months ended March 31, 2004 and 2005, the effect of 224,004 and 722 shares from stock options, respectively, were excluded from the calculation of loss per share as their effect would have been antidilutive and decreased the loss per share.

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Note O Other Long-Term Liabilities:

Other Long-term balances were as follows at:

In the fourth quarter of 2004, we moved into a new facility in Redmond and signed a seven-year lease with a five-year renewal option. As a part of that transaction, we received $900,000 from the landlord as an inducement to enter into the new lease and to cover costs associated with the move. We are required to amortize the $900,000 against rent expense over the term of the lease. Therefore, at March 31, 2005 and December 31, 2004, the long-term portion of the amount to be amortized was approximately $757,000 and $763,000, respectively. We refer to the building in Redmond as Building 4. We also lease three other buildings in the Redmond area.

In the fourth quarter of 2004, we vacated a facility we refer to as Building 1 in Redmond, Washington. We recorded a charge of $382,000 in the fourth quarter of 2004 to recognize future costs associated with the continuing lease obligations for this vacated facility. The charge is net of any future rental income we will receive. The long-term portion attributable to the charge was approximately $213,000 and $247,000, at March 31, 2005 and December 31, 2004, respectively.

In January 2005, we vacated approximately 30,020 square feet in a facility we refer to as Building 2 in Redmond, Washington. We moved all of the operations in that building to our new Building 4. We had 12 months remaining on our lease on Building 2 at the end of January 2005. A charge of approximately $194,000 was recorded in the first quarter of 2005 to recognize future costs associated with the continuing lease obligation for this vacated facility (Building 2). We have undertaken efforts to sublease this facility, and the charge is net of estimated future rental income we expect to receive. At March 31, 2005, the amount to be amortized was all considered to be current.

At the end of March 2005, we vacated an additional 32,650 square feet in a facility we refer to as Building 3 in Redmond, Washington. We moved all of the operations in that building to our new Building 4. A charge of approximately $500,000 was recorded in the first quarter of 2005 to recognize future costs associated with the continuing lease obligation for this vacated facility (Building 3). We have undertaken efforts to sublease this facility, and the charge is net of estimated future rental income we expect to receive. At March 31, 2005, the long-term portion to be amortized was approximately $128,000.

Note P Commitments and Contingencies:

Rent and Lease

In December 2004, we sold our Tempe, Arizona building for approximately $11.3 million, less selling costs of approximately $500,000. At the time of the sale, we entered into an agreement with the buyer to leaseback the entire facility for a period of five years, which extends through December 2009. This facility currently houses our U.S.-based corporate functions. We subleased approximately 56,000 square feet of that Tempe facility to Brillian Corp. for the same five-year period. Brillian pays to us the same lease rate that we pay the lessor on the master lease. If Brillian were to default on its obligation to us, we would still be obligated on the master lease to continue to make payments on the Brillian space. The sublease income we receive from Brillian is recorded as other income.

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Letter of Credit

In accordance with the terms of the lease for one of our facilities in Redmond, Washington, we have issued an unconditional, sight draft letter of credit in the amount of $600,000 to the landlord. The landlord letter of credit is security for our performance of all of our covenants and obligations under the lease. In the first quarter of 2005, Silicon Valley Bank (SVB) required us to make a cash deposit to secure the $600,000 letter of credit. This cash deposit is shown on our Balance Sheet at March 31, 2005 as Cash on Deposit Maintained for Compensating Balances.

Guarantee

In February 2002, we guaranteed up to $500,000 of the debt of a private start-up company, VoiceViewer Technology, Inc., which is developing microdisplay products. This guarantee was assumed by Brillian Corporation in the spin-off. We have not yet been released from our obligation on the guarantee, so if Brillian is unable to satisfy its obligation, then we are secondarily liable and will be required to pay this guarantee to the lender. As of March 31, 2005, our maximum liability under this guarantee was $292,000. This loan guarantee has a five-year term and matures in January 2007.

Note Q Segment Information:

At the end of 2004, we began to review our business performance using two segments: Display and EMS. Within the Display business, our design and manufacturing services included a distinctive competence in display modules and systems and the integration of display modules and systems into other products. Within the EMS business, we design and/or manufacture electronic printed circuit board assemblies, display modules and systems, and complete systems for customers in the computing, consumer, industrial, medical, military, and telecommunications industries. Corporate costs not allocated to operating segments include administrative costs for the chief executive officer, chief financial officer and investor relations as well as accounting, legal and human resource costs in Tempe, Arizona. In the first quarter of 2005, we included facility, information technology and quality assurance costs incurred at our Tempe facility in our unallocated corporate costs. We have restated 2004 segment data to conform with this new presentation methodology. The following results are for our Display and EMS segments and unallocated corporate costs:

We have not disclosed total assets, liabilities, cost of property, plant and equipment acquired, and depreciation expense by segment as this information is not reviewed by the chief operating decision maker, is not produced internally and is not practical to prepare.

We do, however, track net sales and certain property, plant, equipment, and intangibles by geographic location. Net sales by geographic area are determined based upon the location of the end customer, while long-lived

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assets are based upon physical location of the assets. The following includes net sales, property, plant and equipment for our designated geographic areas:

For the quarters end March 31, 2004 and 2005, our sales were distributed over six major markets: computing, consumer, industrial, medical, military and telecommunications. In the first quarter of 2005, 76% of our sales came from the computing market and 10% came from the medical market. In first quarter of 2004, 72% of our sales came from the computing market and 15% came from medical. Our net sales distributed by market were as follows:

Note R Recently Issued Accounting Standards:

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — An Amendment of ARB No. 43, Chapter 4”. SFAS No. 151 amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS No. 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005 and is required to be adopted by us effective January 1, 2006. We are currently evaluating the impact SFAS No. 151 will have on our consolidated results of operations and financial condition.

In December 2004, the FASB issued Statement 123 (R), “Share-Based Payment,” which replaces FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. FASB Statement 123 (R) will require compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity instruments issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. FASB Statement 123 (R) becomes effective for annual periods beginning after June 15, 2005 and is

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required to be adopted by us effective January 1, 2006. At this time, we are in the process of evaluating the impact this will have on our financial statements.

We adopted the provisions of FASB Interpretation No. 46 (Revised), Consolidation of Variable Interest Entities (“Interpretation No. 46 (Revised)”) in our interim period ending March 31, 2004. Interpretation No. 46 (Revised) clarifies the application of existing consolidation requirements to entities where a controlling financial interest is achieved through arrangements that do not involve voting interests. The application of Interpretation No. 46 (Revised) did not have an impact on our financial statements.

Note S Subsequent Events:

In May 2005, we sold the large panel display business operated out of our Marlborough, Massachusetts facility for $1.4 million to Video Display Corp. At March 31, 2005, we had not finalized our plans for this business and not yet committed to a plan to sell the business. As a result, that business will be reported as discontinued operations commencing in the second quarter of 2005. In part based on the lower than expected operating results of this business in the first quarter of 2005, forecasted revenue revisions, and the sale price realized in May 2005, we determined that $7.2 million of goodwill associated with the display monitor business was impaired. This charge appears under Impairment of Goodwill.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS

     The statements contained in this report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of applicable securities laws. Forward-looking statements include statements regarding our “expectations,” “anticipation,” “intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking statements also include statements regarding revenue, margins, expenses, and earnings analysis for fiscal 2005 and thereafter; technological innovations; future products or product development; our product development strategies; potential acquisitions or strategic alliances; the success of particular product or marketing programs; the amounts of revenue generated as a result of sales to significant customers; and liquidity and anticipated cash needs and availability. All forward-looking statements included in this report are based on information available to us as of the filing date of this report, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from the forward-looking statements.

Overview

     We are a global provider of electronics manufacturing services, or EMS. We design and/or manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, and complete systems for customers in the computing, consumer, industrial, medical, military, and telecommunications industries. Our services include advanced engineering support, “designed for” services, automated printed circuit board assembly, in-circuit and functional testing, systems level integration and box build, and turn-key supply chain management services, all of which enable our customers the ability to outsource all stages of product engineering, design, development, materials procurement and management, manufacturing, and testing. Until recently, our design and manufacturing services included a distinctive competence in display modules and systems and the integration of display modules and systems into other products. We refer to the business involving displays as the Display business. All other business other than the Display business is referred to herein as the EMS business.

Current Strategic Plans Regarding the Sale of Remaining Businesses

     We have sustained substantial losses in the past several years. Those losses and certain acquisitions we completed had the effect of reducing our cash balances. As a result, we retained SG Cowen & Company to review

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strategic alternatives aimed at maximizing stockholder value. Based on that review, and as further described below, we have sold or closed down our Display business. We have also signed a letter of intent to sell our business in Manila, which is the radio frequency, or RF, portion of our EMS business, in exchange for cash. This letter of intent is nonbinding; therefore, there is no assurance that any business transaction will be effected or what the timing and terms of any such business transaction will be. If the sale of Manila is completed, our only remaining business will be the Redmond and Penang portions of our EMS business. We continue to use SG Cowen to review strategic alternatives with our remaining business. In the meantime, we continue to focus on cost reductions in that business, including moving our corporate headquarters to Redmond.

     As a result of the foregoing, all of our Display business other than the large format display business in Marlborough, Massachusetts is reported in our financial statements this quarter as discontinued operations, as further described below. In addition, since the RF portion of our business was held for sale in the first quarter, that business is also included in discontinued operations in the first quarter.

Recent Sale Transactions and Discontinued Operations

     In March 2005, we determined to discontinue our distribution of certain display products that we licensed from Data International. The decision follows the exercise by us of our right to rescind a technology licensing agreement, or TLA, that was entered into during January 2003 with Data International Co, Ltd. Revenue from those Data International products in 2004 equaled approximately $17 million. The TLA designated us as the exclusive distributor of certain Data International display products in the Americas in return for deferred payments to Data International of $3.9 million. Through the end of 2004, we had paid approximately $2.4 million to Data International, and a final payment of approximately $1.5 million was due in January 2005.

     We determined in the first quarter of 2005 that certain of the specified Data International display products have been simultaneously available in the United States through a third party and that we had not been provided exclusive distribution rights to the United States market as required by the TLA. Based on that determination, we believe that the TLA was breached, and we exercised our rights of rescission. We notified Data International in February 2005 that we would not make the final $1.5 million payment to Data International that was due in January 2005. We also asserted damages of at least $2.5 million, plus interest and other expenses, against Data International. We notified Data International that we have off-set our claimed damages against money owed by us to Data International for product purchases. We recently filed a complaint against Data International in Arizona requesting a declaratory judgment for breach of contract. Data International also filed a lawsuit against us in federal district court in Arizona asserting breach of contract.

     On March 30, 2005, we signed a definitive agreement to sell the assets of our small form factor display business to International DisplayWorks, Inc. That transaction closed in April. The small form factor display assets sold included 100% of the outstanding shares of Three-Five Systems, Beijing, Inc., our former China-based display subsidiary, and display-related equipment housed at our Manila, Philippines factory. The sale did not include the large panel display monitor business operated out of our Marlborough, Massachusetts facility and our electronic manufacturing services (EMS) business located in Redmond, Washington, Penang, Malaysia, and Manila, Philippines.

     We estimate the total value of the transaction to be in the range of between $8 and $20 million, which will come from a variety of components. These components include the following:

	•	$8 million in cash recently paid to us upon closing and government approval in China;
	•	Up to an estimated $3 million in additional cash to be paid to us over time based upon working capital adjustments; and
	•	An estimated zero to $9 million in the common stock of International DisplayWorks, Inc. to be paid to us in May 2006, based on a percentage of the transferred display business revenue for the preceding 12-month period, if certain minimum revenue targets are met.

     At closing, International DisplayWorks, Inc. assumed the obligations of TFS Beijing, including a $2.4 million line of credit we had previously established with a bank located in China.

     Our display business of products from Data International and our small form factor business were previously part of our Display segment. Sales from these two businesses were $5.8 million and $12.9 million in the first quarters of

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2005 and 2004, respectively. These two businesses generated $9.5 million and $2.4 million of the loss included in discontinued operations in the first quarter of 2005 and 2004, respectively.

     As it relates to our discontinuation of our business related to products supplied by Data International, we recorded a charge of $2.1 million for the write-off of the distribution right purchased from Data International. Since the litigation has not been concluded, however, we have not adjusted the write down of the note payable and outstanding accounts payable.

     In connection with the sale of assets to International DisplayWorks, Inc., we recorded a loss of $5.0 million from the write down of assets, which considered only the initial $8 million received at the closing when calculating the write down on these assets. The various earn-outs were classified as contingent gains and will be recorded by us, if and when received. As a result, we wrote off $2.5 million of inventory, $0.7 million of mask sets, and $1.8 million of property, plant, and equipment.

     We also included our RF business under discontinued operations because during the first quarter we had established a plan to sell this business in 2005. This business was previously part of our EMS segment. As noted previously, we have signed a non-binding letter of intent to sell this business and expect to close by the end of the second quarter. Although the sale cannot be assured, we have used the current estimated sales price of approximately $3.0 million to determine the impairment of assets currently in this business. Sales from this business were $2.1 million and $2.6 million in the first quarter of 2005 and 2004, respectively. The total loss from discontinued operations for the RF business was $5.8 million and $0.4 million in the first quarter of 2005 and 2004, respectively. The impairment of assets totaled $5.2 million in the first quarter of 2005.

     In May 2005, we sold the large panel display monitor business operated out of our Marlborough, Massachusetts facility for $1.4 million to Video Display Corp. At March 31, 2005, we had not finalized our plans for this business and not yet committed to a plan to sell the business. As a result, that business will be reported as discontinued operations commencing in the second quarter of 2005. In part based on the lower than expected operating results of this business in the first quarter of 2005, forecasted revenue revisions, and the sale price realized in May 2005, we determined that $7.2 million of goodwill associated with the display monitor business was impaired. This charge appears under Impairment of Goodwill.

     Refer to our Form 10-K filed April 1, 2005 for a detailed description of Acquisitions and Strategic Transactions that occurred in 2004 and prior years.

Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles (GAAP) in the United States. During preparation of these financial statements, we are required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to sales returns, bad debts, inventories, fixed assets, goodwill, intangible assets, income taxes, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

     We assemble and manufacture products for our customers and recognize revenue when persuasive evidence of a sale exists: that is, a product is shipped under an agreement with a customer; risk of loss and title have passed to the customer; the fee is fixed or determinable; and collection of the resulting receivable is reasonably assured. This means that when a product is shipped from one of our factories under the terms “FOB Factory” then the risk of loss passes to the customer when the product leaves our factory and we recognize revenue at that time. On the other hand, when a product is shipped under the title transfer terms of “FOB Destination” then the risk of loss during transit is maintained by

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us. Thus, we recognize revenue when the product is accepted by the customer. Shipping terms with one of our major customers is FOB Destination, and many of those products are shipped by sea, taking four to six weeks to reach their destination. As a result, we frequently have a significant amount of product in transit recorded in our finished goods inventory. At March 31, 2005, we had $2.5 million of product in transit compared with $3.1 million at December 31, 2004.

     We estimate sales allowances based upon historical experience of sales returns. To establish our allowance for doubtful accounts, we perform credit evaluations of our customers’ financial condition, along with analyzing past experience, and make provisions for doubtful accounts based on the outcome of our credit valuations and analysis. We evaluate the collectability of our accounts receivable based on specific customer circumstances, current economic trends, historical experience with collections, and the age of past due receivables. We believe the allowances that we have established are adequate under the circumstances; however, a change in the economic environment or a customer’s financial condition could cause our estimates of allowances, and consequently the provision for doubtful accounts, to change. In the first quarter of 2005, we reserved $0.4 million of our receivable from Vitelcom, a former European customer. This adjustment is included under discontinued operations.

     We scrap inventory when materials are determined to be defective, damaged, or no longer required. We also write down our inventory for estimated obsolescence or unmarketable inventory based upon assumptions and estimates about future demand and market conditions. If actual market conditions are less favorable than those projected by us, additional inventory write downs may be required. In the first quarter of 2005, we wrote off $0.7 million of inventory, primarily in our EMS segment, which primarily related to discontinued programs and excess inventories in our Redmond, Washington facility.

     Pursuant to Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, income taxes are recorded based on current year amounts payable or refundable, as well as the consequences of events that give rise to deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax laws and rates that are currently in effect in the appropriate jurisdiction. Changes in tax laws or rates may affect the current amounts payable or refundable as well as the amount of deferred tax assets or liabilities.

     Long-term assets, such as property, plant, and equipment, intangibles, goodwill, and other investments, are originally recorded at cost. On an ongoing basis, we assess these assets to determine if their current recorded value is impaired. When assessing these assets, we consider projected future cash flows to determine if impairment is applicable. Assets may also be evaluated by identifying independent market values of assets that we believe to be comparable. If we believe that an asset’s value is impaired, we write down the carrying value of the identified asset and charge the impairment as an expense in the period in which the determination is made. In the first quarter of 2005, we determined that $5.7 million of goodwill in our EMS reporting unit and $7.2 million of goodwill in our Display reporting unit had been impaired. The amount of the impairment was determined in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. The decision to impair the goodwill was the result of first quarter 2005 operating results, forecasted revenue revisions, the recent sale of the Marlborough business in May 2005 and valuations set forth in indications of interest we have recently received with respect to one or more of our businesses in our EMS segment. In May 2005, we completed the sale of our Marlborough business for $1.4 million which indicated that $500,000 of goodwill should be recorded at March 31, 2005. During the first quarter of 2005 within our discontinued operations, we also impaired $5.2 million of assets related to our RF business, and $7.1 million of assets (including inventory) related to our two discontinued Display businesses.

Results of Operations

Three months ended March 31, 2005 compared to three months ended March 31, 2004

     Net Sales. Net sales decreased 12.2% to $20.2 million in the first quarter of 2005 from $23.0 million in the first quarter of 2004. The decrease in year-over-year quarterly revenue was primarily a result of reduced sales in the

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computing, industrial, and medical markets. Sales in both our Display and EMS segments were lower in the first quarter of 2005 compared with the first quarter of 2004. Geographically, our sales were lower in both the US and European markets. We had only one customer that accounted for more than 10% of our net sales in the first quarter of 2005 and 2004, and that customer, which is in the computer peripherals business, accounted for 66% and 59% of our net sales, respectively. The sales in our top six markets (in thousands) on a comparative quarterly basis are broken down as follows:

     Sales in our two segments, in millions, were as follows:

     Gross Margin. Our gross margin equals the difference between our revenue and our cost of sales. Our gross margin in the first quarter of 2005 was a negative $1.9 million, or 9.4%, compared with a positive $0.7 million, or 3.0% in the first quarter of 2004. The negative gross margins in the first quarter of 2005 were caused by several factors, including excess capacity in the manufacturing facilities and operational issues. In addition, our reduced manufacturing volumes resulted in under-absorption of our fixed manufacturing costs. In the first quarter of 2005, we wrote off $0.7 million of excess inventory, primarily in our EMS segment, which related primarily to discontinued programs and excess inventories at our Redmond, Washington facility. In the first quarter of 2004, we wrote off just over $1.0 million of inventory relating to a supplier’s defective component. The gross margin dollars in our two segments and for unallocated corporate costs for the periods ended March 31, 2004 and 2005, respectively, in millions, were as follows:

     Corporate costs include corporate manufacturing costs, plus costs related to facility, information technology and quality assurance allocations incurred at our Tempe facility.

     Selling, General, and Administrative Expense. Selling, general, and administrative expense increased to $6.7 million in the first quarter of 2005 from $4.2 million in the first quarter of 2004. SG&A expense was 33.3% of net sales in the first quarter of 2005 compared with 18.1% of net sales in the first quarter of 2004. This increase in SG&A expense occurred primarily due to the $0.9 million cost of vacating and moving to a new facility in Redmond, Washington, $0.3 million cost incurred due to the cancellation of a hosting contract that will no longer be needed as a

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result of terminating the ERP implementation, $0.6 million increased severance, and consulting, and $0.3 million of higher accounting and legal expenses.

     The SG&A expense in our two segments and for unallocated corporate costs for the periods ended March 31, 2004 and 2005, respectively, in millions, were as follows:

     The increase in EMS costs in the first quarter of 2005, compared with the first quarter of 2004 was primarily the result of expenses associated with vacating and moving our operations in Buildings 2 and 3 in Redmond, Washington, to our new Building 4. Those costs totaled $0.9 million.

     Corporate costs include all unallocated finance, IT, HR, and administrative costs. Those costs increased primarily because of the costs associated with the cancellation of the hosting contract related to the ERP implementation of $0.3 million, as well as the increased costs of severance and consulting of $0.6 million and higher accounting and legal expenses of $0.3 million.

     Research, Development, and Engineering Expense. Research, development, and engineering expense decreased to $233,000 in the first quarter of 2005 from $248,000 in the first quarter of 2004. Research, development, and engineering expense was 1.2% of net sales in the first quarter of 2005 compared with 1.1% in the first quarter of 2004.

     The RD&E expense in our two segments and for unallocated corporate costs for the periods ended March 31, 2004 and 2005, respectively, in millions, were as follows:

     Impairment of Goodwill. During the first quarter of 2005, we reduced the goodwill on our balance sheet relating to our EMS and Display reporting units. The write-off of goodwill (Display segment, $7.2 million, EMS segment, $5.7 million) was $12.9 million.

     Loss on Impairment and Disposal of Long-Lived Assets. In the first quarter of 2005, we made the determination that we would not proceed with the implementation of a new ERP system. This decision resulted in a loss of $2.5 million from the write-off of the ERP software and implementation costs.

     Amortization of Intangibles. Amortization expense was $166,000 for the first quarter of 2005 compared with $318,000 for the first quarter of 2004. The amortization in 2005 related to the acquisition of ETMA customer lists in December 2002. Amortization expense in 2004 also included amortization of customer lists acquired in our acquisition of AVT in September 2002.

     Other Income, Net. Other income was $259,000 in the first quarter of 2005 compared with $169,000 in the first quarter of 2004. The composition of the items that make up other income was as follows (in thousands):

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     Interest income decreased as a result of lower cash and short-term investment balances. Interest expense decreased primarily due to our capital leases. The rental and service income increased as a result of the sublease of our facilities which includes sub-leasing part of our Tempe building to Brillian Corporation.

     Minority Interest. As of March 31, 2004, we controlled and owned only 60% of the business in Malaysia, and we recorded an expense of $80,000 to account for the profits allocated to the minority interest holder. We now own 100% of the business in Malaysia and thus no longer have a minority interest adjustment.

     Provision for (Benefit from) Income Taxes. We recorded a provision for income taxes of $15,000 in the first quarter of 2005 compared with a benefit from income taxes of $112,000 in the first quarter of 2004. The benefit in the first quarter of 2004 was for tax refunds.

     Net Loss. Our net loss was $39.4 million in the first quarter of 2005, or $1.81 per diluted share, compared with $6.6 million, or $0.31 per diluted share in the first quarter of 2004. Our loss from continuing operations in the first quarter of 2005 was $24.2 million, or $1.11 per diluted share, compared with a loss from continuing operations in the first quarter of 2004 of $3.8 million, or $0.18 per diluted share. Our net loss in the first quarter of 2005 from discontinued operations was $15.2 million, or $0.70 per share, compared with a net loss from discontinued operations of $2.8 million, or $0.13 per diluted share, in the first quarter of 2004.

Liquidity and Capital Resources

     At March 31, 2005, we had cash and restricted cash, of $12.4 million, compared with $16.2 million at December 31, 2004.

     In reviewing our condensed consolidated statement of cash flows, we had $2.9 million in net cash outflow from operations in the first quarter of 2005, compared with $2.8 million in net cash outflow from operations in the first quarter of 2004. Our inventory turns were 5.1 and day sales outstanding, or DSOs, were 46 days in the first quarter of 2005 compared with 5.1 inventory turns and 38 DSOs in the first quarter of 2004. Our depreciation and amortization expense was $1.0 million in the first quarter of 2005 compared with $1.1 million in the first quarter of 2004. We had purchases of property, plant and equipment of approximately $1.4 million, which included $0.4 million invested in our ERP implementation project and $1.0 million of equipment purchased in Redmond and Penang.

     During the first quarter of 2005, we had payments on our capital leases of $0.7 million. Most of those payments related to our capital leases for our manufacturing equipment in Penang.

     Our working capital was $20.6 million at March 31, 2005, down from $26.9 million at December 31, 2004. Our current ratio at March 31, 2005 was 1.5-to-1 compared with 1.7-to-1 at December 31, 2004. The decrease in working capital was primarily because of reduced cash and accounts receivable balances.

     While we transact business predominantly in U.S. dollars and invoice and collect most of our sales in U.S. dollars, we collect a portion of our revenue in non-U.S. currencies, such as the Chinese Renminbi. In the future, customers increasingly may make payments in non-U.S. currencies, such as the Euro. In addition, we account for a portion of our costs, such as payroll, rent, and indirect operating costs, in non-U.S. currencies, including Philippine Pesos, British Pounds Sterling, Malaysian Ringgit, and Chinese Renminbi. Thus, fluctuations in foreign currency exchange rates could affect our cost of goods and operating margins and could result in exchange losses. In addition,

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currency devaluation can result in a loss to us if we hold deposits of that currency. Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We cannot predict the impact of future exchange rate fluctuations on our operating results. These currency risks are particularly important since sales outside North America represented 33% of our net sales in the first quarter of 2005 and 37% of our net sales in the first quarter of 2004. Sales in foreign markets, primarily Europe and Asia, to OEMs based in the United States accounted for almost all of our international sales in both of these periods.

     In the second quarter of 2004, we entered into a $10.0 million secured revolving line of credit with Silicon Valley Bank, or SVB, which matures on June 25, 2005. Although there were no borrowings under the SVB line as of December 31, 2004, we were in violation of our covenants relating to cash earnings and revenue. SVB did not declare a default on the line, but we are currently under discussion with SVB with regard to a re-negotiation of the terms of the line. During this re-negotiation period, SVB has issued a forbearance letter under which we are precluded access to the line. In addition, SVB required us to make a cash deposit in the first quarter of 2005 to secure a $600,000 letter of credit, which SVB had issued to the lessor of our building in Redmond.

     In the second quarter of 2004, our Beijing subsidiary secured a $2.4 million line of credit with Hua Xia Bank secured principally by our building in Beijing. We had borrowed $2.4 million under that facility at March 31, 2005 and at December 31, 2004, which accrues simple, annual interest at 5.31%. The loan is included in Current Liabilities of Discontinued Operations and was assumed by International DisplayWorks, Inc. upon the sale of our Beijing subsidiary.

     The following tables list our contractual obligations and commercial commitments as of March 31, 2005:

     ¹ This obligation is included in Current Liabilities of Discontinued Operations as of March 31, 2005. In January 2003, we signed a term loan of $2.9 million with Data International. In the first quarter of 2004, we paid $1.4 million against the term loan. The remaining $1.5 million was due in January 2005. We notified Data International in February 2005 that we would not make the final $1.5 million payment and have filed a complaint against Data International in Arizona requesting a declaratory judgment for breach of contract. In April 2005, Data International filed a complaint against us alleging we have breached the license agreement. (See Part II, Item 1. Legal Proceedings, for additional disclosures).

     ² This obligation is included in Current Liabilities of Discontinued Operations as of March 31, 2005. This obligation will be assumed by International DisplayWorks, Inc. at the closing of our sale of our small form factor display business. That transaction closed in April.

     ³ Includes approximately $173,000 of obligations that will be assumed by International DisplayWorks, Inc. at the closing of our sale of our small form factor display business. That transaction closed in April.

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     ⁴ Includes approximately $14,000 of obligations that will be assumed by International DisplayWorks, Inc. at the closing of our sale of our small form factor display business. That transaction closed in April.

     The operating leases include leases for our factories in Penang and Washington, our former factory in Massachusetts, our lease in Arizona, and our sales offices in Florida and in the United Kingdom. The capital leases are for our equipment in Malaysia and Washington. One of the capital leases includes certain financial covenants that we were not in compliance with at December 31, 2004. The lessor has advised us they are accelerating the payments due on the lease obligations. As of March 31, 2005, we were in negotiations with the lessor to resolve the non-compliance. The guarantee relates to our guarantee in connection with a Small Business Administration loan to VoiceViewer Technology, Inc., a privately held company developing microdisplay products. Brillian Corporation assumed this guarantee in the spin-off. If Brillian Corporation were unable to satisfy its obligation as primary guarantor, then we would be required to pay the guaranteed amount.

     We have no other long-term debt, capital lease obligations, unconditional purchase obligations, or other long-term obligations, and we do not have any other commercial commitments or other off-balance sheet arrangements.

     Our cash balance (including compensating balances) as of March 31, 2005 was $12.4 million. We recently received $8 million for the sale of our small form factor display operations to International DisplayWorks, Inc and $1.4 million for the sale of our large format display operations to Video Display Corp. We believe that our cash on hand will provide adequate liquidity to fund our remaining operations and planned expenditures through 2005, as well as to meet our contractual obligations. In addition, we are expecting to obtain a $4 million line of credit in Malaysia, which could then be used in the Malaysian EMS business. We also have signed a nonbinding letter of intent to sell our RF business in Manila, which will provide additional cash if such transaction closes. Although we believe that we have adequate sources of funds through the rest of 2005, this belief is based on our judgments and forecasts. Actual results could prove materially different and, in such instances, may require additional funds. We cannot provide assurance that additional asset sales, such as the sale of the Manila operations, loan commitments, or other methods of financing will be available for any such unexpected additional requirements or, if available, that they will be on terms acceptable to us.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     There are no material changes in the reported market risks since our most recent filing on Form 10-K for the year ended December 31, 2004.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Control and Procedures

     Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our principal executive officer and principal financial officer have concluded that as of such date, our disclosure controls and procedures were designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in applicable SEC rules and forms were effective.

Changes in Internal Control over Financial Reporting

     There have been no significant changes in our internal control or in other factors that could significantly affect those controls subsequent to our evaluation, including corrective actions with regard to significant deficiencies and material weaknesses.

     While we have not identified any material weaknesses or conditions in our disclosure controls and procedures, we continually monitor those controls and procedures to identify deficiencies and weaknesses and correct those items as necessary. It should also be noted that we are planning to move our corporate headquarters to Redmond, Washington

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during the second and third quarters of 2005. That move, along with the consolidation of our operations, has resulted in recent and substantial turnover in the finance and operations functions, including the chief financial officer, chief manufacturing officer, director of internal audit, and others.

PART II

ITEM 1. LEGAL PROCEEDINGS

Data International Company, Ltd.

     In January 2003, we signed licensing and manufacturing agreements with Data International Co., Ltd. of Taiwan. Under those agreements, we agreed to pay $3.9 million to become the exclusive channel in the Americas for LCD products manufactured by Data International. During the first quarter of 2005, we determined that certain of the specified Data International display products have been simultaneously available in the United States through a third party and that we had not been provided exclusive distribution rights to the United States market as required by the license. Based on that determination, we believe that the license was breached and we exercised our rights of rescission. In April 2005, we filed a Compliant for breach of contract in the Maricopa County Superior Court in Phoenix, Arizona. In April 2005, Data International filed a Complaint in the United States District Court in Arizona. Data International alleges that we have breached the license agreement and we owe Data International monies due under the license and manufacturing agreement. Neither party has responded to the Complaint of the other and no discovery has yet been taken.

Vitelcom

     In the first quarter of 2005, we filed a lawsuit against Vitelcom in Spain for the amounts due to us under a revised payment schedule. As of December 31, 2004, $1.4 million remained unpaid. At March 31, 2005, the amount remained outstanding. During the first quarter of 2005, we reserved $0.4 million against this unpaid amount.

     We are also involved in certain administrative proceedings arising in the normal course of business. In our opinion, the ultimate settlement of these administrative proceedings will not materially impact our financial position or results of operations.

ITEM 5. OTHER INFORMATION

     Our Insider Trading Policy permits our directors, officers, and other key personnel to establish purchase and sale programs in accordance with Rule 10b5-1 adopted by the Securities and Exchange Commission. The rule permits employees to adopt written plans at a time before becoming aware of material nonpublic information and to sell shares according to a plan on a regular basis (for example, weekly or monthly), regardless of any subsequent nonpublic information they receive. In our view, Rule 10b5-1 plans are beneficial because systematic, pre-planned sales that take place over an extended period should have a less disruptive influence on the price of our stock. We also believe plans of this type are beneficial because they inform the marketplace about the nature of the trading activities of our directors and officers. In the absence of such information, the market could mistakenly attribute transactions as reflecting a lack of confidence in our company or an indication of an impending event involving our company. We recognize that our directors and officers may have reasons totally apart from the company in determining to effect transactions in our common stock. These reasons could include the purchase of a home, tax and estate planning, the payment of college tuition, the establishment of a trust, the balancing of assets, or other personal reasons. The establishment of any trading plan involving our company requires the pre-clearance by our Chief Executive Officer or Chief Financial Officer. An individual adopting a trading plan must comply with all requirements of Rule 10b5-1, including the requirement that the individual not possess any material nonpublic information regarding our company at the time of the establishment of the plan. In addition, sales under a trading plan may be made no earlier than 30 days after the plan establishment date.

     No officers currently maintain trading plans.

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ITEM 6. EXHIBITS

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	THREE-FIVE SYSTEMS, INC.
Date: May 19, 2005	By:	/s/ Jack L. Saltich
		Jack L. Saltich
		President and Chief Executive Officer
Date: May 19, 2005	By:	/s/ James E. Jurgens
		James E. Jurgens
		Interim Chief Financial Officer (Principal Financial Officer)

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* Filed herein.